Marko Kolanovic, head of quantitative and derivative strategies at J.P. Morgan Securities, writes clients this afternoon that he thinks the CBOE Volatility Index is about three points too low. That judgment is based on its history versus variables like employment, manufacturing, consumer and housing data, all of which have historical relationships of varying strength.

Kolanovic argues that market volatility “appears to be disconnected from fundamentals, and pressured by structural effects.” What structural effects? One of them is fewer hedge funds and proprietary traders, who tend to drive up stock-market volume, and volume tends to rise with volatility. Per Kolanovic:

[T]here is much less trading activity now as compared to the 2004-2007 time period. The left figure below shows a nearly 50% decline of equity share volumes since 2007. Volume and volatility are highly correlated (figure middle, current low volumes/volatility are denoted with a red dot). Volatility and volumes are linked by a positive feedback loop (lower volumes lead to lower volatility and vice versa). Lower market activity is likely due to relative decline in activity of levered investors such as hedge funds and prop desks, and relative increase from less active investors such as corporates performing buybacks, or asset managers increasing equity allocations. Relatively high valuation of equities are also not supportive of higher volumes and volatility, as value driven investors gradually step away from the market.

The other factor, of course, is the Federal Reserve. Note the phrase “low yield environment”:

Low realized volatility, and the low yield environment further invite volatility sellers of all shapes and forms which is putting further pressure on implied volatility measures such as the VIX. … the low yield environment and support from central banks is currently keeping volatility low not just in equities but across asset classes.

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